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Honors Projects Economics Department
2007
Analyzing the Relationship between change in Money Supply and Stock Market Prices
Biniv Maskay '07 Illinois Wesleyan University
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Biniv Maskay and Dr. Margaret Chapman Department of Economics, Illinois Wesleyan University
This paper examines the relationship between change in the money supply and the level of stock prices. This paper also dichotomizes change in the money supply into anticipated and unanticipated change and analyzes each oftheir relationships with stock market prices. Competing theories exist on how change in the money supply affects stock prices. The real activity theorists argue that change in the money supply and stock prices are positively related, where as the Keynesian economists argue otherwise. This study finds a positive relationship between change in the money supply and stock prices, agreeing with the real activity theorists. Economists also debate on the relationship of anticipated and unanticipated change in money supply with the stock market prices. The proponents of the Efficient Market llypothesis (EMH) argue that anticipated change in money supply would not have a significant impact on stock prices and only unanticipated change in the money supply would matter, whereas the opponents of EMH argue that anticipated change in money would matter too in detennining the stock prices. This paper finds that anticipated change in money supply matter more than unanticipated change, failing to find efficiency in the stock market. I. Introduction Billions ofdollars worth ofshares are traded in the stock market on a daily ·basis.
Many people depend on. the stock market as their 11ri.n1.ary source ofincome while others have tIleir retirement funds tied to the stock market. TIle importance of"good" perfonnance ofthe stock market is obvious. History has shown that a downturn in stock prices can cause major disturbances in the lives ofmany. Also, the strength of a stock
Inarket can h.ave a major effect on the economy through its intl.uence on real activities such as consumption, investlTIent, etc.
Monetary policy is one ofthe n1.ost effective tools that a central bank has at its disposal. In fact, lTIany economists consider monetary policy as the most important macroeconolnic IJolicy. The central bank uses monetary policy frequently to cause a desired level of change ill real activities. These frequent changes ill monetary policy are believed to have a significant effect on the stock market. It is in1.portant to analyze the relationship between the nlost eflective economic policy, llamely lTIOnetary policy, and one im.portant deterrn.inant ofthe economy, the stock market. In this study, I analyze this delicate yet crucial relationship between monetary policy and the stock market.
Specifically, I look. at the relationship between the money sUP11ly and stock market prices. Money supply is one ofthe components oflTIOnetary policy that the
Federal Reserve uses. Changes in m.oney supply can be either anticipated or ullanticipated by the people. It is believed that anticipated and 'unanticipated changes in the lTIOney supply affect the stock lTIarket differently. Taking this point into consideration,
I differentiate the anticipated and ·unanticipated components ofchanges in the money supply and analyze how each. affects stock market prices. Maskay 2
In Section II, the theoretical fralne\\'ork is discussed along with the relevant literature on the topic. Next, ill Section III, the variables and data set utilized in this study are described and the empirical model is developed. Results are presented and discussed in Section IV. The paper COllcludes with Section V, ill which suggestions for further studies are pointed out and policy implications are co.nsidered.
II. Theory and Review of Literature
The price of a stock is determined by the present value ofthe future cash flows.
The present value ofthe future cash flows is calculated by discounting the future cash flows at a discount rate. Money supply has a significant relationship with the discount rate and hence with the present value of cash flows.
Sellin (2001) lays out competing theories on how the money supply affects the stock market prices. The competing theories to be examined here are the ones developed by the Keynesian economists and the real activity theorists. Keynesian economists argue that there is a negative relationship between stock prices and money supply whereas real activity theorists argue that the relationship between the two variables is positive (Sellin,
2001).
The Keynesian economists argue that change in the money supply will affect the stock prices only if the change in the money supply alters expectations about future monetary policy. According to them, a positive money supply shock will lead people to anticipate tightening monetary policy in the future. They bid for funds in anticipation of tightening ofmoney supply in the future, which will drive up the current rate ofinterest.
As the interest rate goes up, the discount rates go up as well and the present value of Maskay 3 future earnings falls. Stock prices consequently decline. Furthennore, they argue that economic activities decline as a result ofincrease in interest rates, which further depresses stock prices (Sellin, 2001).
The real activity economists believe that change in money supply, assuming accommodating monetary policy, provides infonnation on money demand. In other words, they argue that increase in money supply means that money demand is increasing in anticipation of increase in economic activity. Higher economic activity implies higher expected profitability, which causes stock prices to rise. Hence, the real activity theorists argue that there is a positive relationship between money supply and stock prices (Sellin,
2001).
Sellin also discusses the risk premium hypothesis proposed by Cornell. Cornell argues that money is held as opposed to alternate assets for precautionary motives and money demand is directly proportional to risk and risk aversion. An unexpected money supply increase indicates higher money demand given an accommodating m'onetary policy. Higher money demand suggests increase in risk. As a result, investors demand higher risk premium for holding stocks making them less attractive, which causes equity prices to fall (Sellin, 2001).
Bernanke and Kuttner (2005) combine the real activity and risk premium hypotheses and argue that the price of a stock is a function ofthe present value of future returns and the perceived risk in holding the stock. The authors believe that there is a positive relationship between the money supply and stock prices, agreeing with the real activity hypothesis but disagreeing with Cornell's risk premium hypothesis. A stock is attractive ifthe potential ofhigh returns is high. On the other hand, a stock is unattractive Maskay4 ifthe perceived risk ofholding it is high. The authors argue that the money supply affects the stock market through its effect on both present value offuture returns and the perceived risk. Money supply affects the present value of future returns through its effect on the interest rate. The authors believe that a tightening ofthe money supply raises the real interest rate. An increase in the interest rate would in tum raise the discount rate, which would decrease the present value offuture returns, which in tum decreases the price of a stock (Bernanke and Kuttner, 2005).
Unlike Cornell's risk hypothesis, Bernanke and Kuttner argue money supply changes and the risk premium vary inversely. Tightening ofthe money supply would increase the risk premium that would be needed to compensate the investor for holding the risky assets because it symbolizes a slowing down ofeconomic activity, which reduces the potential ofthe firms to make a profit. Investors would be bearing more risk in such a situation and hence demand more risk premium for holding stocks. The risk premium makes the stock unattractive which would lower the price ofthe stock
(Bernanke and Kuttner, 2005).
It is possible that both the Keynesians and the real activity theorists are correct in their predictions about the effect ofthe changes in the money supply on stock market prices but the two opposite effects offset each other. I will analyze which theory dominates the other, or in other words, what direction the stock prices take as the money supply changes.
Another debate regarding money supply and stock prices is that stock prices are believed to react differently to the anticipated and unanticipated component ofthe money supply. Sellin, in his review article, discusses works of Cornell, Pearce and Roley, Hafer Maskay 5 and Hardouvelis concerning the issue, and points Ollt varied results obtained by these studies (2001). The economists involved in this debate disagree on the extent to which the market is efficient. The proponents ofthe efficient market hypothesis hold that all available information is already embedded in the price ofa stock. Hence, they argue that anticipated changes in money supply would not affect the stock prices and only the unanticipated component of a change in money supply would affect the stock market prices. The opponents ofthe efficient market hypothesis, on the other hand, contend that all available infonnation is not embedded in the prices and hence, the anticipated changes in money would affect the stock prices too (Corrado and Jordan, 2005).
Sorensen studies the impact ofmoney on stock prices with special attention to anticipated and unanticipated changes in money supply. Sorensen's study is particularly important for my study because my empirical model follows his empirical model very closely. He uses a two-stage regression model in his analysis. In the first stage, he replicates Barro's model ofmoney supply where money supply is regressed against previous money supplies, unemployment rate and real federal government expenditure. In the second stage, the stock index is regressed upon anticipated money growth using estimates ofthe regression ofthe first stage. Residuals ofthe first stage equation are used as the unanticipated component, which is regressed upon a stock index to figure out the effect ofunanticipated conlponent. Sorensen finds that unanticipated changes in the money supply have a larger impact on the stock market than anticipated changes, supporting the efficient market hypothesis (Sorensen, 1982).
Bernanke and Kuttner also analyze the anticipated and unanticipated components ofthe monetary policy but they looked at the impact of announced and unannounced Maskay6 changes in the federal funds rate on equity prices rather than anticipated and unanticipated changes in money supply. Observations used in the model are the days in which federal funds rates were changed corresponding to the Federal Open Market
Committee (FOMC) meetings. This way, they are easily able to identify the anticipated and unanticipated components by looking at the discrepancies between FOMC reports and the actual change in rates. They use a vector autoregression model on 131 observations from June 1989 to December 2001, excluding September 2001. The authors find a higher reaction by the stock market to unannounced changes in the federal funds rate, again supporting the efficient market hypothesis (Bernanke and Kuttner, 2005).
Unlike previous studies discussed, Husain and Mahmood fails to find evidence efficiency in the market. Husain and Mahmood studies the relationship between monetary expansion and stock returns in Pakistan. M1 and M2 are used as dependent variables and stock indices ofsix sectors were used as independent variables. An Augmented Dickey
Fuller test is used to find a relationship between the money supply and both short run and long run changes in stock market prices (Husain and Mahmood, 1999). The study finds that change in money supply causes changes in stock prices in both short and long run, suggesting that the stock market is not efficient with respect to money supply changes, or in other words, finding that the efficient market hypothesis does not persist (Husain and
Mahmood, 1999).
This study will also dichotomize the money supply into anticipated and unanticipated components, and analyze their relationship with the stock prices. This study expands on previous work by adding several control variables, which are discussed in section III. This study is different from Bernanke and Kuttner's study because the Maskay 7 dependent variable is the money supply rather than the federal fund rate. This study is also different from Husain and Mahmod's study because it analyzes u.s. stock market prices as opposed to Pakistan's stock market prices.
In sum, following from the theory and review of literature, this paper seeks to study the following:
1. Is there a relationship between change in money supply and level of stock prices?
If there is, what is the direction of the relationship? Do the stock prices behave as
the Keynesian economists argue or as the real activity theorists argue?
2. Do stock market prices react differently to anticipated and unanticipated changes
in the money supply? Does the efficient market hypothesis persist?
III. Empirical Model
1. Effect of change in the money supply on stock market prices
This section is divided into two parts. In the first part, I test for the relationship between change in money supply and change in stock prices. The actual change in money supply is regressed upon the S&P 500 index to carry out the test. All nloney variables and the S&P 500 index are in real terms consistent with Laopodis's (2006) study. The results ofthis section allow us to see ifthe stock prices behave as the Keynesians argue or as the real activity theorists argue.
I use M2 for the money supply variable. M2 is defined as an aggregate of currency, demand deposits, other checkable deposits, travelers' check outstanding, saving deposits and money market deposit account, snlall time deposits and retail purchase of money market mutual fund (Fisher, 2001). The use ofM2 in the model is consistent with the variable used by Sorensen, and Husain and Mahmood in their studies. The data for Maskay 8 the money supply (M2) are obtained from Federal Reserve Economic Data (FRED) ofthe
Federal Reserve Bank of S1. Louis website,
Monthly data ofM2 are averaged out to produce quarterly data.
The data for S&P 500 index are obtained from Yahoo Finance website,
Mathematically, the empirical model is,
Modell:
S&P500 = at + a2*Actual change in money Sllpply + a3*Consumer confidence
+ 84*GDP + as*unemployment rate (1)
I add several control variables in the model in addition to actual change in the money supply variable. Consumer confidence is a very important influence in the stock market. When consunler sentiments rise, people tend to be less risk averse. Hence, they are willing to hold more oftheir assets in the form of equities, which are considered riskier investments than holding assets in cash or other fixed income securities such as bonds. As the demand for equities increases, so do their prices. People do exactly the opposite when confidence falls. So, a positive relation is expected between consumer confidence and stock market prices. The data for consumer confidence compiled by
University ofMichigan are used and obtained through FRED. Monthly data of consumer confidence are averaged over three months to produce quarterly data.
Another control variable added in the model is real GDP. Most industries are pro cyclical in nature, meaning that the firms in the industry do well as the economy does well and vice versa. If the GDP is high, the stock prices generally tend to be high, as the Maskay9 companies would be doing better than otherwise. So, GDP is an important determinant of the stock prices and should be included in the model. A positive relationship is expected between stock prices and GDP. The data for GDP are obtained from FRED.
The unemployment rate is also an important variable because it is a major factor that determines the demand for equity. When the unemployment rate is low, more people can afford to hold shares ofthe firms, which drives the demand and subsequently prices ofthe stocks. Also, the unemployment rate is a proxy for overall aggregate demand in the economy. When the unemployment rate is low, aggregate demand is high, which indicates a healthy environment for the companies to operate in. So, a negative relation is expected between stock prices and unemployment rates. The data for unemployment rates are obtained from FRED.
2. Effect of anticipated and unanticipated change in the money supply on stock market prices
A two-stage regression model is used in the second part ofthe section. In the first stage, Barro's money supply equation is closely followed as his model has received wide approval from economists in the field. The independent variables in the model are past money supply, unemployment rate and real federal government expenditure. Specifically, my first stage model is as follows:
(2) where
UNt = log(unemployment rat~ /(1 - unemployment rat~)), Maskay 10
FEDVt = log(real federal expenditur~) -log (FED*t), and
Log(FED*t) = 0.2(log(FEDt)) + 0.8(log(FED*t-l))'
DMt, here, is defined as a difference in change in money supply in quarter t from change in money supply in same quarter ofprevious year. In other words, DMt is defined as a difference in quarterly money supply year over year. Unemployment rate is used to capture a countercyclical policy response in money supply. Increase in unemployment rate could lead the Fed to adopt easy monetary policy and thus increase money supply.
Hence, a positive relation between unemployment rate and money supply is expected.
Federal government expenditure is included to control for fiscal policy. Including federal government expenditure captures the activity of financing government expenditure through money creation. A positive relation between government expenditure and nl0ney supply is expected as well.
Barro calculates Log(FED*t) using a adaptive expectations model. It is assumed that what will happen in future is based on what has happened in the past. Here, he obtains the log of expected federal government expenditure at time t is obtained through a weighted sum ofthe log of actual government expenditure at time t and the log of expected government expenditure at time t-l. He applies weights of 0.2 and 0.8 respectively.
The difference between my model and Barro's model is that Barro uses log differences in quarterly money supply year over year while I use linear difference in quarterly money supply year over year. One advantage ofusing my transformed Barro's model is that it makes the interpretation ofthe results easier. Maskay 11
In the second stage, the change in money supply predicted by Barro's 1st stage regression ofthe money supply is measured against the actual change in money supply obtained from FRED. The resulting difference between the actual change in money supply and the predicted change in money supply as predicted by 1st stage model is the unanticipated component ofthe money supply.
Mathematically, the relationship between actual, anticipated and unanticipated changes in money supply is as follows:
Unanticipated change in money supply = DMt - DMt*,
where DMt is actual change in money supply and,
DMt * is the predicted money supply from equation 2.
The unanticipated change in the money supply could be positive or negative. If the actual change is greater than the predicted change, the resulting difference is a positive unanticipated change in money supply. On the other hand, ifthe actual change is less than the change predicted by the model, the unanticipated change is negative.
Differentiating positive and negative unanticipated money supply is crucial as it enables me to assess the impact ofeach variable on the stock prices. If I had only one variable, the unanticipated positive might offset the unanticipated negative giving me ambiguous results.
These anticipated and unanticipated changes in money supply are regressed upon the S&P 500 index to see ifthe efficient market hypothesis persists.
Mathematically, the second empirical model is, Maskay 12
Model 2:
S&P500 = b 1+ b2 *anticipated change in M2 + b3* unanticipated positive change in M2
+ b4*llnanticipated negative change in M2+ bs* consumer confidence
(3)
The same control variables are added in model 2 as in model 1. The expected sign for each control variables in this model is the same as the expected sign in model 1. The result from this model should show us the direction of stock market price changes caused by positive and negative unanticipated change in money supply and also the difference in their impact.
IV. Results
1. Results of Model 1
Table 1 provides descriptive statistics ofthe actual change in money supply, real
S&P 500 index, and other control variables.
Table 1: Descriptive Statistics
Variables N Mean Standard Deviation
S&P 500 114 365.9573 215.2593 Actual change in M2 114 49.1119 76.8746 Consumer Confidence 114 88.083 12.121 Unemployment rate 114 6.1636% 1.1414 GOP 114 $4629.955 945.9436
The result ofModel 1 is presented in Table 2. The actual changes in money supply are regressed against the real S&P 500 index in this model. Maskay 13
Model 1 shows that there is a positive relationship between changes in the money supply and stock prices. The results support the real activity theorists' argument that an increase in the money supply increases stock prices and vice versa.
Table 2: Modell, Dependent variable = S&P 500 index Variables Coefficient Sig. -152.266 Constant 0.265 (-1.121)
0.465 Actual change in M2 0.000 (3.712)
.842 Consumer Confidence 0.346 (.947) 0.146 Real GDP 0.000 (12.169) -41.169 Unemployment rate 0.000 (-4.783)
R Squared 0.873 N 114 t-value in parenthesis
The results for the control variables are also consistent with the argument I made in section III. The results show that consumer confidence and GDP are positively related to the stock prices and the unemployment rate is l1egatively related to stock prices as argued.
Also note that change in money supply, real GDP, and unemployment rate are highly significant at a 0.01 level. Consumer confidence is insignificant variable at a 0.1 level. The R squared is .873, meaning that the model explains 87.3% ofthe variance in stock prices.
In order to conceptualize the results, I did some simulations connecting descriptive statistics in table 1 and the results in table 2. The results shows that when the Maskay 14 money supply increases by $49.1119 billion (average change in quarterly money supply, year over year), the S&P 500 index increases by 22.83 points, about 1.61 % ofcurrent index (as ofMarch 30, 2007).
2. Results of Model 2
The result ofthe 1st stage regression of Model 2 is provided in Table 3.
Table 3: Result of 1st Stage Regression of Model 2 Variables Coefficient Sig. Constant 4.448 0.795 (.260) RDM_lag1 1.507 .000 (21.898) RDM_lag2 -.714 .000 (-6.158) RDM_lag3 .343 .004 (2.936) RDM_lag4 -.718 .000 (-6.158) RDM_lag5 .939 .000 (7.920) RDM_lag6 -.463 .000 (-6.552) UN_lag1 101.996 .242 (1.175) UN_lag2 -24.682 .871 (-.163) UN_lag3 -76.88 .376 (-.888) RFEDV 59.656 .213 (1.250) R Square 0.931 N 178 t-value in paranthesis
By using the results as presented in table 3, the anticipated and unanticipated change in money supply is computed. Table 4 provides descriptive statistics ofthe result obtained on predicted and residual money supply change. Maskay 15
Table 4: Descriptive Statistics Variables N Mean Standard Deviation Anticipated Change in M2 114 48.4485 74.4839 Unanticipated Positive 114 8.8746 13.3071 Unanticipated Negative 114 -8.2113 12.6841
The results ofModel 2 are presented in Table 5. The anticipated change, unanticipated positive change and unanticipated negative change in money supply are regressed against the real S&P 500 index in this model.
Table 5: Model 2, Dependent variable =S&P 500 index Variables Coefficient Sig. Constant -149.88 0.278 (-1.090) Anticipated change in M2 0.473 0.000 (3.612) Unanticipated Positive 0.268 0.682 (0.411) Unanticipated Negative 0.599 0.379 (0.884) Consumer Confidence 0.8 0.029 (0.883) GDP 0.147 0.000 (11.77) Unemployment rate -41.178 0.000 (-4.716) R Squared 0.873 N 114 t-value in parenthesis
The most important conclusion that can be drawn from the result ofmodel 2 is that anticipated changes in the money supply matter more than unanticipated change. As argued in section II, the proponents ofthe Efficient Market Hypothesis argue that anticipated change in the money supply does not matter in predicting stock prices and only unanticipated change does. The opponents ofthe Efficient Market Hypothesis, on the other hand, argue that anticipated change in the money supply nlatters too. The result Maskay 16 in table 4 shows that anticipated change in money supply matters more than unanticipated changes as both unanticipated components are not significant at a .1 level, whereas the anticipated change is highly significant at a .01 level. So, the results support critics of
Efficient Market Hypothesis and signify that anticipated change in money supply matters too. The result is consistent with the results found by Hussain and Mahmod.
The results for control variables are consistent here too with the argument I make in earlier sections. The results show that consumer confidence and GDP are positively related to the stock prices and unemployment rate is negatively related with stock prices as argued. Also, as in Modell, real GDP and unemployment rate are highly significant at a 0.01 level, whereas consumer confidence is not significant at 0.1 level.
The results suggest that when the anticipated money supply changes by $48.4485 billion (average change in anticipated money supply), the S&P 500 index increases by
22.91points, about 1.61 % ofcurrent index. Similarly, when the unanticipated positive money supply increases by $ 8.8746billion (average change in unanticipated money supply), the S&P 500 index increases by 4.2 points, about 0.29% of current index.
Similarly, when the unanticipated negative money supply increases by $8.211 billion
(average change in unanticipated money supply), the S&P 500 index increases by 4.92 points, about 0.35% of current index.
I also tried alternate ways in analyzing the relationship between anticipated and unanticipated change in money supply. I tested a model where I do not dichotomize the unanticipated money supply into unanticipated positive and unanticipated negative. The result for the model was similar to the one presented in this paper, where unanticipated Maskay 17 changes in money supply were found to have positive but insignificant effect on the stock prices.
I also considered a model where change in money supply greater than the sum of actual change and ~ standard deviation of actual change is considered as unanticipated positive change in money supply and change in money supply less than the difference of actual change and ~ standard deviation of actual change is considered as unanticipated negative change in money supply. The result for this model too was similar to the one presented in paper where anticipated change in money supply had positive and significant effect on the stock prices and both unanticipated positive and unanticipated negative changes in money supply had positive but insignificant effect on the stock prices.
VI. Conclusion
The results ofthis study suggest that the real activity hypothesis dominates
Keynesian theory. The results support the view ofthe real activity hypothesis that a positive money supply shock would increase the stock prices and vice versa. The results also support the opponents of Efficient Market Hypothesis that anticipated change in money supply matter more than unanticipated changes in money supply in determining the stock prices.
Several policy implications can be drawn from this study. The government, in formulating monetary policy, must be aware of the fact that the stock market responds more favorably to an increase in the money supply. The government must also be conscious that the stock prices tend to increase when the government implements expansionary policy to increase GDP and decrease unemployment rates. Maskay 18
The other implication that is clear from the study is that the central bank should give enough indication to the market on its plans of changing money supply. As the anticipated changes matter more than the unanticipated changes, the more the people could anticipate change in money supply correctly, the better the effect ofchange in money supply would be translated into real activity.
The models presented in the study, however, are not free ofdrawbacks. Sorensen
(1982) points out that using estimates and residuals from Barro's model to dichotomize anticipated and unanticipated component is arbitrary. As I follow Barro's model closely, my model could have this drawback too. However, Sorensen is quick to defend the model by arguing that there is no single model that all the participants ofthe stock market would be using (Sorensen, 1982).
One way ofeffectively and accurately assesing the anticipated and unanticipated change in the money supply would be to replicate Bemanke and Kuttner's model as discussed in section II but using money supply rather than federal fund rate. By measuring the money supply corresponding to the FaMe announcements, the difference between announced and the actual could be calculated resulting in the unanticipated component on the nloney supply, which wOlLld be far more accurate that the one presented by the model in this study.
Using S&P 500 index as a dependent variable itself could be a limitation ofthe model. Even though S&P 500 is a most widely used benchmark and some even consider the performance of S&P 500 as the performance ofthe market, it is important to note that the index only comprises of 500 large capitalized (bigger than $5 billion in market value) companies. Therefore, this study ineffectively leaves out the performance ofthe other Maskay 19 companies that are not included in S&P500. Studies in the future could include more comprehensive indices along with S&P 500 index to capture the effect on stock prices of middle and small capitalized companies through change in money supply. Works Cited
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Fisher, Dougals. Intermediate Macroeconomics: A Statistical Approach. New Jersey:
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Husain, Fazal, and Tariq Mahmood. "Monetary Expansion and Stock Returns in
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Laopodis, Nikiforos T. "Dynamic Interactions among the Stock Market, Federal Funds
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Sellin, Peter. "Monetary Policy and the Stock Market: Theory and Empirical Evidence."
Journal of Economic Surveys 15.4 (2001): 491-541.
Sorensen, Eric H. "Rational Expectations and the Impact ofMoney upon Stock Prices."
Journal ofFinancial and Quantitative Analysis 17.5 (1982): 649-62.